August 21, 2008

Consider a Loan

Is it just me or is Angel/VC funding really exciting?  Seriously, could there be more of a professional self-esteem boost than getting funded?

…but as with most “perfect” scenarios, equity funding has its trade offs.  Let me give you a very possible scenario with Angel funding…

The Story

Okay, say you have a really great high tech idea that you are going to build and sell to Google someday.  (Don’t we all?)  You are pre-revenue, but have such a good business plan and pitch that an angel investor has valued your company at $2MM and is willing to give you $500k for 25% of it.  Great, right?!

So you get to work and bring in $1MM of revenue in your first year with not much profit, but great traction and you are ready for year two.  In year two you double the revenue to $2MM and make $400k in profit.  Now you find yourself in a situation to fund your business with cash it generates.  In year three, you double again with $4MM revenue and the profit continues to scale.  You keep up this rapid pace with internally generated cash in years four and five with $8MM and $16MM revenue respectively.

At this point, your business is valued by Google itself at $40MM, and the hoped for day actually happens when Google mails you a check for that amount and you hand over the keys.  Victory!

The Real Cost

Just as you rent out Disney Land for a day for all of your, now former, employees; you open your mailbox and find a bill.  The bill is from your angel investor–$10MM due upon receipt.

Commentary

Okay, so yeah, things wouldn’t work quite that way.  First, the whole mailed $40MM check, $10MM bill thing–that was just to make you laugh.  Although, the economic consequences might be similar.

Second, to have a business with that kind of success is rare, but having a business that needs some seed money and then rises to prominence with its own cash can happen.

What To Do

Make some good five-year financial projections.  You’ll want to anyway if you want an investor to consider you.  Angels typically want five to seven times what they put in, and they want it in five to seven years.  In the case above, however, the angel would get 20 times in five years.

If you really do have a company that needs a significant sum to get started, but should be able to fund itself into doubling every year, consider angel debt (or other forms of debt) instead.  Let’s look at the same scenario again.

The Remix

This time let’s say you get an angel debt deal for $500k with a three year, 25% APR, annual payment terms.  Just to make things simple–let’s say that translates into you making a $125K payment at the end of year one, a $125k payment at the end of year two, and a $625k payment at the end of year three.   By that time, you are internally funded and you have paid a total of $875k back to the angel.  The angel is happy with the 25% APR return, and you you just saved yourself a lot of your company when you go to sell.

The Third Alternative

It may be hard to get a loan that size so you might need to do a debt/equity combination deal, which also could be a better scenario than a pure equity deal.

Conclusion

Angel equity is awesome!  Angels help make the small to medium business world go!  Sometimes, however, we should probably look at debt (possibly angel debt) instead of angel equity.

Go to www.fundinguniverse.com for helping determining your best plan of action to getting funded.

For entrepreneurship topics and tips not related to fundraising see Lance’s blog Entrepersonal.